Question

Part A

Pearson Ltd is financed through the following sources:

•  Ordinary share: 100 million shares outstanding, with current market price of

  one share at $2.2

•  Bank loan: $100 million borrowed from ANZ bank with an interest rate of 6%

•  Corporate bond: Pearson’s corporate bond is currently trading at 80% of its

  face value. The bonds pay coupons once per annum and have a total book value of $100 million. The current yield to maturity on the bond is 8% per annum.

  The risk-free rate is 3% and the market risk premium is 6%. It is estimated that Pearson has an equity beta of 1.5. Assume corporate tax rate is 30%, calculate the WACC for Pearson Ltd.

  Part B

  According to M&M proposition II, cost of equity increases with leverage. Cost of debt will also increase with leverage given higher probability of default. As both cost of equity and cost of debt are increasing when leverage increases, does it mean that leverage is bad for the firm value?

  Part C

  It can be observed that the average gearing ratio for the Pharmaceuticals industry is much lower than industries such as Utilities and Transportation. Explain why this is the case.

Answer 1

2.
No this is not the case because WACC falls and value rises.

Debt is cheaper than equity and additionally, interest payments are tax deductible so after tax effective cost of debt is much cheaper than equity so even when cost of both debt and equity is rising, WACC falls upto a point. Hence, leverage till that point is actually good for the firm value. Leverage beyond that point is bad for the firm value when WACC actually starts rising.

3.
Gearing ratio varies because of different capital intensity levels between industries and whether the nature of the business makes carrying a high level of debt relatively easier to manage. We see that pharmaceuticals is a highly volatile business i.e., has high business risk in the sense that the R&D expenses might not always give the desired profits and many R&D costs would go waste. There is also no certainty in the cash flows. As debt requires fixed payments, sufficient cash flow needs to be generated by the business which pharmaceutical companies might find difficult at times. However, utilities and transportation businesses are stable businesses and have certain-steadier and more predictable cash flows. So, they have higher gearing ratio than pharmaceuticals.

Only allowed one yet have answered two